Claim the Foreign Taxes Paid as an Itemized Deduction
Beginning for 2021, Schedules K-2 and K-3 must be included with a domestic partnership’s Form 1065 or S corporation’s Form 1120-S when these entities have items of international tax relevance. They are rather long forms.
Unexpectedly the IRS noted in the forms’ instructions that if a partner or shareholder paid foreign taxes and filed Form 1116 on their 1040, that would trigger the requirement for Schedules K-2 and K-3 to be included by the entity, even when the entity had no international income, expenses, etc.
Unless the IRS backs off on smaller entities, that means each partner or shareholder must be contacted to se if they paid foreign taxes and if they plan to file Form 1116.
There are a couple of workarounds. One option is to claim the taxes on Schedule A as “other taxes” (line 6). Taxes entered on line 6 are not subject to the $10,000 SALT limitation.
The other option, where certain conditions are met, is that the foreign tax credit can be claimed without Form 1116.
This election is available only if the taxpayer meets all the following conditions (does not apply to estates and trusts):
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The creditable foreign taxes don’t exceed $300 ($600 if married filing a joint return).
Example – Creditable Foreign Taxes: Country X withholds $25 of tax from a dividend payment made to the taxpayer. Under the income tax treaty between the U.S. and Country X, the taxpayer only owes $15 and can claim a refund from Country X for the other $10. Only $15 is eligible for the foreign tax credit (whether or not the taxpayer applies for a refund).
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Foreign taxes withheld on a dividend from a corporation are not eligible for the credit if the taxpayer hadn’t held the stock for at least 16 days within the 31-day period that begins 15 days before the ex-dividend date.
This required holding period is greater for preferred-stock dividends. Similarly, foreign taxes withheld on income or gain (other than dividends) from property aren’t credit-eligible if the taxpayer hadn’t held the property for at least 16 days within the 31-day period that begins 15 days before the date on which the right to receive the payment arises.
See the instructions to Form 1116 for other situations when foreign taxes aren’t creditable.
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All the foreign source gross income on which the foreign tax was assessed was passive category income which includes most interest and dividends. However, passive category income can include other sources of income rarely encountered by individuals and small businesses. See the Form 1116 instructions for additional information.
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All the income and any foreign taxes paid on it were reported to the taxpayer on a qualified payee statement. Qualified payee statements include Form 1099-DIV, Form 1099-INT, Schedule K-1 (Form 1041), Schedule K-3 (Form 1065), Schedule K-3 (Form 1120-S), or similar substitute statements.
If this election is made certain restrictions apply:
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Unlike when using Form 1116, the taxpayer can't carry over to or from any other year any foreign taxes paid or accrued in a tax year to which the election applies (but carryovers to and from other years are unaffected).
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The taxpayer is still required to take into account the general rules for determining whether a tax is creditable.
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Taxes paid on earned income excluded using Form 2555 cannot be included when figuring the credit.
To make the election, enter on the foreign tax credit line of the tax return (Schedule 3 (Form 1040)), Part I, line 1) the smaller of (a) the total foreign tax credit, or (b) the regular tax.